Speech Financial Stability: Review and Response

I'd like to thank CPA Australia for the invitation to speak to you today. As
you may know, we recently released our twice-yearly Financial Stability Review. Most of what I have to say today draws
heavily from that document. I would like to cover the main themes we have been
focusing on, as described in the Review, before concluding with a couple of
points of particular relevance to the accounting profession.

It's now more than three years since the turmoil first started in overseas
interbank markets. And it's just over two years since Lehman Brothers
failed. Conditions in the global financial system started to recover last year,
and continued to do so over the past six months. But global financial markets
remain prone to bouts of uncertainty. We saw an example of that in April and
May, when concerns about Greek government finances spilled over into bank funding
markets.

The latest data suggest the financial strength of Australian banks is continuing
to improve. The domestic non-financial sectors also seem to be in a fairly
sound state. Both households and businesses seem to have become a bit more
cautious: that is probably a good thing, in that it might buttress their resilience
to any future shocks that could come along. In short, Australia has come through
the global disruptions of recent years in reasonably good shape. But the lessons
of the crisis are still being absorbed, and in the policy community there is
still much work to be done.

The Global Scene

The initial convulsion of 2007 and 2008 might seem to be over, but there's
no doubt that the after-effects remain. In the boom phase of any cycle, investors
pay little mind to the risks they run. All the talk is optimistic; all the
expectations are of asset prices rising seemingly forever. The shocks that
do occur are shrugged off.

But after the crisis has occurred, it is as if people can think only of risk, of what could go wrong. So it has been in the recent
period. Before the crisis, markets were little perturbed by many events that,
in other circumstances, might have triggered a panic. A hedge fund might fail;
a small country's exchange rate might drop suddenly; or some US mortgage
companies might start to collapse. All these things happened in 2006. Yet risk
spreads stayed low, and the structured finance production machine kept chugging
on (Graph 1).

Graph 1

But since Lehman Brothers failed in September 2008, along with distress and collapse
at other firms, risk aversion has increased. Markets seem more skittish. Smaller
bouts of turbulence broke out, as concerns moved first to eastern Europe, then
to Dubai. So when attention turned to countries like Greece, we saw that in
the current, risk-averse, environment, a weak economy and fiscal position would
no longer be ignored.

Greece was hardly involved in the original crisis of 2007 and 2008. Greek banks'
exposure to poor-quality US housing-related assets was essentially zero. They
were not major counterparties of the global financial firms that failed or
became distressed, such as Bear Stearns or Lehman Brothers. Like any banking
system, though, Greek banks are highly exposed to their domestic sovereign
– both directly via bond holdings and funding spreads, and indirectly
via the economy. Once concerns about Greece's fiscal position flared,
it was not surprising that its banks were also affected. Loan losses in a weak
economy only exacerbated those fears. Bank share prices fell (Graph 2).

Graph 2

Then investors started worrying about the exposures of banks in other countries to
Greece's government and banks. Other countries with weakened fiscal positions
started to face scrutiny. Euro area countries faced a double burden in this
situation. Unlike countries with their own currency, it is harder for them
to get a boost to growth from a depreciating exchange rate, because they share
a currency with many of their most important trading partners.

More recently, these concerns seem to have eased off somewhat. The joint European/IMF
rescue package and the public stress testing of banks have both helped assuage
some uncertainties. But markets remain concerned about Greece and countries
such as Ireland. We can see this in risk spreads in sovereign debt markets,
as well as in banks' share prices.

Looking at the global financial system more broadly, the picture is one of tentative
improvement. Major banking systems have returned to profitability, which is
helping them to rebuild the capital they need. In large part, this is because
bad loan charges are now falling, as the economy improves (Graph 3). There
are, however, large differences across countries, and across different types
of bank in the same country.

Graph 3

The Australian Financial System

In contrast to the banking systems in the United States or Europe, the Australian
banking system has come through the last few years quite well. Banks and other
deposit-taking institutions in Australia remained profitable in aggregate throughout
the period. The sector remains well capitalised. And their bad and doubtful
debt charges have started to turn down, especially at the major banks. The
upshot is that return on shareholders' equity for both the major and
smaller Australian banks dipped, but not very far in the scheme of things (Graph 4).
And for both groups of banks, profitability has already started recovering.

Graph 4

The quality of banks' assets did not deteriorate as much as in the last downturn
in the early 1990s. The stock of their domestic assets that are considered
impaired or otherwise non-performing is still drifting up in dollar terms.
But there are signs it might be nearing a peak. As a share of all loans on
their domestic books, non-performing assets seem to be stabilising (Graph 5).

Graph 5

Part of the reason why this ratio has stabilised relates to the composition of banks'
balance sheets. Compared with the early 1990s, a much smaller fraction of their
domestic balance sheets is comprised of business lending, which is riskier
in general. It also tends to deteriorate faster in an economic downturn. Housing
lending has become more important to lenders over the past 20 years. The
trend continued more recently, as housing lending expanded while business credit
contracted.

In passing, I would note that Australian banks have almost no exposure to Greece
or the other smaller euro area countries.

Over the past couple of years, Australian banks took a number of actions to buttress
their liquidity and funding positions. They now rely less on short-term wholesale
funding, and more on funding sources that are considered more stable. Among
these is deposit funding. Banks and other deposit-takers have increased deposit
interest rates relative to market rates, making deposits more attractive to
savers. In fact, growth in deposits has actually outpaced that in credit over
the past couple of years (Graph 6).

Graph 6

The Links to the Non-financial Sectors

Policymakers' concerns about financial stability stem, in the end, from the
effects that the financial system can have on the real economy. We care about
financial crises because of the economic and human costs they entail, not because
of any direct concern for the financial firms themselves.

Policymakers must also be mindful of the feedback from the real economy to the financial
sector. If the non-financial sectors are resilient to shocks, the financial
system will not face as large losses from loans gone bad in a downturn. So
we pay a lot of attention to the financial situations of the household and
business sectors. We examine their balance sheets in detail. And we focus on
lending standards, that is, the terms on which they are borrowing. These are
hard to measure, but it is vital to track them. If either households or businesses
were to overstretch themselves, they would become vulnerable to any macroeconomic
or financial setback.

Our reading of recent data is that the Australian household and business sectors
have, in aggregate, entered a phase of expansion. But they seem to be showing
more financial caution than they did prior to the crisis. Although wage incomes
and profits were quite soft during late 2008 and 2009, the effects of monetary
and fiscal policy stimulus largely cushioned this. As the effects of policy
wane, we are now seeing some hand-off back to employment income and profit
growth.

At the same time, the housing market has probably cooled somewhat. Growth in dwelling
prices has tapered off in recent months, especially in more expensive suburbs.
Housing credit growth has slowed. New lending to first-home buyers reverted
to closer to its historical share of loan approvals after the additional government
grants expired (Graph 7). The difference has not so far been made up by
other types of buyers. In particular, loans to property investor households
have not surged the way they did during the more buoyant, rather speculative
period in the early 2000s.

Graph 7

Businesses have entered the current upturn with stronger balance sheets in aggregate
than they had at the peak of the global credit boom. Profitability has recovered
to more normal levels. The outlook for mining company profits is particularly
strong, for obvious reasons. But even before this turnaround, many firms had
been using their internal funds to strengthen their finances, often to replace
debt funding that had become more expensive and less available. Gearing ratios
for listed firms have declined considerably as a result, especially for those
firms and industries that were most leveraged before (Graph 8).

Graph 8

The Policy Response

The crisis and its aftermath hold many lessons for policymakers. The international
system for regulation of banks needed to be improved. So did the way it had
been implemented in some countries. The crisis showed that many banks around
the world needed more capital. And they needed better-quality capital that
could absorb losses while the bank was still a going concern.

The community of international regulators have been hard at work developing a new
capital standard to meet this need. Recently the Basel Committee on Banking
Supervision agreed on new capital requirements for banks. Previously, banks
were required to hold a minimum amount of capital equal to 8 per cent of assets
weighted by their riskiness. They also had to hold at least 4 per cent
of risk-weighted assets in higher-quality so-called ‘Tier 1’ capital.
There was no explicit standard for common equity – the most loss-absorbing
kind of capital. But depending on how national supervisors interpreted the
word ‘predominant’, banks could hold as little as 2 per cent of
risk-weighted assets in that form of capital.

The new Basel standards set a new minimum for common equity of 4½ per cent
of risk-weighted assets, and 6 per cent for Tier 1 (Table 1). They
also involve a new ‘conservation buffer’ of 2½ per cent
of common equity. Banks are likely to meet this buffer in normal times. Otherwise
they will be subject to limits on their dividends and bonus payments. Including
the buffer, the new standards imply that banks will hold at least 7 per
cent of common equity, up from as little as 2 per cent. At 8½ per
cent, the Tier 1 capital requirement including the buffer will be more than
double the previous minimum.

Table 1: New Capital Requirements

Per cent

Common equity

Tier 1 capital

Total capital

Minimum

4.5

6.0

8.0

Conservation buffer

2.5

Minimum plus conservation buffer

7.0

8.5

10.5

Counter-cyclical buffer range(a)

0 to 2.5

(a) Common equity or other fully loss-absorbing capital

Source: GHOS

There are also other changes involved in these reforms. Some instruments that used
to count as capital will be excluded under the new standard; these will have
to be replaced. Certain intangible and other assets will not be treated as
having value, so they will have to be deducted from capital. And a range of
other assets, including those most affected by the crisis, will have higher
risk weights applied to them. So a 7 per cent capital ratio under the old system
won't equal 7 per cent under the new system. How different the number
could be will vary across banks and countries. The difference is probably smaller
for Australian banks than some other places.

As you may have read, we expect that the Australian banks would already meet these
requirements, or so nearly that they could do so quite easily. This is partly
because APRA already required them to deduct many of the things that are newly
required to be deducted under the Basel standards. Australian banks also don't
tend to have large trading books, holding assets of the kinds that are to have
higher risk weights under the new system. But for some banks in other countries,
the task of reaching the new minimum, plus the buffer, is quite large.

The Basel reforms to capital are an important element in the international policy
response to the crisis. But I would not want to give the impression that this
was the only thing that needed to be done. Focusing only on capital would be
like saying that all we needed to do to stop people being injured in car crashes
was to ensure they all had big enough airbags. But bigger airbags are not enough.
We also need safer driving, diligent policing and better roads.

For safer driving, we need to look to the people behind the wheel. As my colleague
Guy Debelle recently pointed out, in the lead-up to the crisis, financial institutions
had been seriously underestimating the risks they were
running.[1] Since the crisis, they are being more cautious. But it's a hard way to
learn the lesson. And eventually memories will fade and the reckless driving
will start again. Of course sometimes people are minded to drive more carefully
if they think they might be booked. So we also need to encourage better driving
with diligent policing.

For diligent policing, read prudential supervision. Prudential regulation is only
one part of the framework for ensuring the safety of the financial system.
Supervision – how the rules are enforced – is arguably even more
important. The Australian prudential regulator, APRA, has long taken a relatively
conservative line compared to their counterparts in some other countries. They
have enforced somewhat tighter rules in some areas than the Basel Accord required.
But they have also placed a lot of emphasis on supervision. The importance
of good supervision recently received strong international
support.[2] We don't want banks to think that they are so well capitalised that it
doesn't matter how much risk they take, or what kinds. There needs to
be some limits to the total amount of risk-taking in the system. That is where
supervision fits in.

For better roads, read financial infrastructure. There is a huge amount of work going
on at both national and international levels to improve the infrastructure
of financial markets, particularly for derivative securities traded over the
counter, not on exchanges.

Another way of getting better roads is to have clearer signs and lane markings. Banks
need to know where they are, and regulators and investors need to be confident
that they know too. I am, of course, referring to the importance of robust
and reliable accounting standards. One of the things that went wrong in the
crisis was that confidence in structured financial securities collapsed. Mortgage-backed
securities and collateralised debt obligations (CDOs) were among those most
affected. Some of these securities never really traded in liquid markets. Their
values were supposedly marked-to-market, but some of those prices were ‘guesstimates’
at best. Investors didn't know how much these securities were worth.
And they panicked because they didn't know which banks held them and
were therefore facing large unrealised losses. That uncertainty was a large
part of the reason why distress in one relatively small market in a single
country – the US sub-prime mortgage market – spread to other
markets until it snowballed into a full-scale global banking crisis.

As this audience would know – almost certainly better than I do – there
have been a number of important and welcome changes to international accounting
standards of late. Several more are still out for consultation. I would like
to point out two today. The first relates to how complex securities are valued.
In short, it does not make sense to mark-to-market when the market doesn't
really exist. The second relates more to the traditional lending business of
banks. New rules for recognising impairments will allow banks to accumulate
loan-loss provisions before explicit signs of impairment on those loans are
observed. Accounting standards serve the needs of many different stakeholders,
and I am conscious that there are diverse views about this change. From a financial
stability perspective, at least, this change is welcome, because it encourages
banks to provision for future loan losses better. Perhaps more importantly,
it might reduce the incentives they face to make risky loans that seem profitable
in a boom, but only because it was a boom.

So as you can see, even though Australia was relatively less touched by the crisis,
there is still plenty to do. And as the economic expansion unfolds, we will
need to be alert for signs that excessive risk-taking has emerged once again.